S Corporations, more commonly referred to as S Corps, are a tax designation under subchapter S of the Internal Revenue Code. Whereas LLCs and corporations are formed when they file legal paperwork with their respective state, an S Corp is designated when an already existing limited liability company (LLC) or corporation (C Corp) files Form 2553 (Election by a Small Business Corporation) with the IRS.S Corps are organized and operated like corporations, but they receive “pass-through” taxation like an LLC. Let’s take a look at how the S Corp measures up to both.
Advantages of an S Corp vs. LLC
When you’re an LLC owner, you’re not an employee, you’re a business owner. This means that every dollar of profit is subject to self-employment taxes (Social Security taxes and Medicare taxes). The IRS requires that you pay Medicare tax on all of your income, whereas Social Security gives you a break with it’s income tax ceiling. This leaves the LLC owner with a 15.3% hit to the bank account. However, this can change if the LLC elects to be taxed as an S corp.
Unlike the default LLC, where all your income is taxed in one lump sum, the income from an S Corp can be divided into two groups: dividends, and what the IRS calls “a reasonable salary.” In short, the salary portion of your income will be subject to the 15.3% self-employment tax, but the dividend portion will escape the tax man! Does this mean that you can take a $10,000 salary on $100,000 earnings, and distribute the remaining $90,000 on the back end? No. You risk the IRS’s wrath after you if you pull that nonsense.
The IRS expects that your salary will be commensurate with local economic conditions, and at a comparable rate of someone with your experience. For example, if your neighboring competitors earn $60,000 a year, you’d probably pay yourself $60,000 and distribute the rest of the $40,000 in dividends. While the $60,000 will be subject to self-employment taxes at 15.3%, the remainder goes untaxed. An LLC owner would be subject to $15,300 in self-employment taxes in this scenario, but because they elected to be taxed as an S Corp, they’ll end up with a smaller bill of $9,180. That’s a savings of 40%!
Advantages of an S Corp vs. Corp
Most corporations that choose to be taxed as an S Corp do so in order to lighten their tax bill. Ordinarily a corporation is taxed twice, once on profits, and again when dividends are distributed to shareholders. However, a corporation can avoid this “double taxation” by electing S Corp status. Just as an LLC offers “pass-through” taxation, so does an S Corp. In this way the S Corp designation is advantageous because the corporation’s shareholders will be taxed on their individual profit distributions, and the business itself will avoid being taxed. Going from being taxed twice to being taxed only once means that the S Corp election can save the corporation and its owners some serious cheese!
S Corp Election Requirements
To become an S Corp, an eligible LLC or corporation must meet certain requirements:
The business must be a domestic corporation or LLC.
Shareholders must be US citizens or lawful residents.
An S Corp cannot exceed 100 shareholders or members, though family shareholder rules allow for members of a family to be treated as a single shareholder for purposes of the shareholder limit.
The S Corp election must be approved by all shareholders or members.
Profits and losses must be distributed in proportion to each shareholder’s ownership percentage.
S Corps are only allowed to issue one class of stock.
Certain financial institutions, insurance companies, and domestic international sales corporations (DISCs) are ineligible.
Steps to Subchapter S Election
Entity Formation: Remember, an S Corp is not formed in the same way that a business entity is formed. A business elects to be taxed as an S Corp. So from the start, if you haven’t already formed a corporation or LLC, doing so will be your first step. In order to form your business entity you’ll need to file paperwork with your respective state. If you already have your corporation or LLC filed with the state, then you’re halfway home.
Research: You’ll need to perform due diligence to make sure your business meets all of the IRS’s S Corp requirements. As a warning, do not play hard and loose with the IRS. Businesses caught breaking S Corp rules can be subject to three years of back taxes, immediate revocation of S Corp status, and a five-year ban from being able to apply for S Corp status.
IRS Form 2553: All shareholders or members must sign and date column K of the form, or submit a separate signed statement of consent. LLCs and corporations that meet all S Corp requirements have 75 days after the start of the tax year to file Form 2553 for the current tax year. This means if your business’s tax year ends on December 31st, you’ll need to make the S Corp election and file Form 2553 by March 15th of the following year.
Acceptance of S Corp Election: The IRS should get back to you within 60 days of filing. Once accepted, your S Corp will be good to go and will remain in effect until the shareholders choose otherwise, or unless the IRS revokes it.
Is the S Corp Designation Recognized By All States?
It should be noted that while the S Corp is recognized federally, not all states and jurisdictions accept the election. New Hampshire, Tennessee, Texas, New York City, and Washington DC all tax S Corps in the same manner as C Corps. This means that S Corps in those states (or jurisdictions) pay corporate income taxes at the state level.
Louisiana treats S Corps as C Corps, but it does allow them to subtract from their taxable income the portion on which S Corp shareholders have already paid Louisiana income tax.
California taxes every S Corp a minimum franchise tax of $800, or 1.5% of income, whichever is greater. They do waive the minimum tax on newly formed or qualified S Corps filing an initial return for their first taxable year if the S Corp did not conduct any business in California during the tax year, or the tax year of the business was 15 days or fewer.
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For many small businesses, the S Corporation offers the best of both worlds, combining the tax advantages of a sole proprietorship or partnership with the limited liability and enduring life of a corporate structure.
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